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February 21, 2012

Tax Avoidance Strategies for Small Businesses, Like Your Advisory Firm

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After estimating my 2011 federal tax liability, I made it my mission to find a legitimate way to reduce the amount I send to Washington. What I found was encouraging. If your current business form is a pass through entity, you are paying taxes at the personal level. If this is the case, this could be especially beneficial. A C Corp is taxed at 15% up to $50,000 and at 25% on the next $25,000 (up to $75,000). The concept is to divide your income over multiple entities. Here's the basic strategy.

The Case Study

Assumptions:

Gross Income: $175,000

Business Overhead: $40,000.

Individual Filing Status: Married Filing Jointly

Itemized Deductions: $25,000

Personal Exemptions: 4 (@ $3,700 each)

Tax Year: Calendar Year 2012

Social Security Wage Base Maximum: $110,100

Medicare Wage Base Maximum: Unlimited

This is a very basic example, so we'll forgo any tax credits, retirement plan contributions, etc. First, we'll look at the tax liability using a pass-through entity. Then we'll use the same facts when you include a C Corp.

Pass-Through Entity Only

Federal Income Tax: As a pass-through entity, you'll claim your business deductions on Schedule C. After deducting your overhead, your net self-employment income would be $135,000 ($175,000 - $40,000). This amount is entered on your 1040 and is reduced by your itemized deductions and personal exemptions, leaving a taxable income of $95,200. The resulting federal income tax liability would be $15,860.

Social Security Tax: The 2.0% "payroll reduction tax" applies to "employees" only. Therefore, using the Social Security maximum wage base amounts, your SS tax liability would be as follows: Medicare tax $3,915 and Social Security tax $13,652. The total Social Security tax would be $17,567

Total Tax: $33,427

Adding a C Corp

The C Corp deducts the $40,000 from its total income of $175,000. Then, after paying you a salary of $100,000, it is left with $35,000. The C Corp also has to pay one-half of the Social Security tax of $7,650 ($100,000 x 7.65%). This would result in a taxable income of $27,350. The resulting tax would be $4,103 ($27,350 x 15%)

As an employee of the C Corp, your gross income would be your salary of $100,000. After deducting your itemized deductions and personal exemptions, your taxable income would be $60,200. The total federal income tax would be $8,160.

Your portion of the Social Security tax would be $4,200 ($100,000 x 4.2%), and Medicare tax of $1,450 ($100,000 x 1.45%). Therefore, your total Social Security tax would be $5,650.

Total Tax:

Personal: $13,810

Corporate: $4,103

Total Tax: $17,913

Taxes saved as a result: $15,514!

In summary, what we have done is spread out your income, keeping each bucket in a lower marginal bracket. You'll have to run the numbers for your situation, but suffice it to say that the savings can be rather dramatic.

In addition, if you add a corporate retirement plan, a Section 125 plan, etc, the benefits would be even greater. Why does a C Corp make so much sense? Could it have something to do with the powerful lobby of the American corporation? After all, that's the business entity of choice for most all major companies.